STOCK GYAN. (Part – 9)Atul Khurana
Till the previous parts, we had discussed completely about Long Term Debt Asset Class Instruments and started with Short Term Debt Asset class instruments under which we had discussed:
- Bond Futures & Options on Bond Futures
- Interest Rate Swaps
- Interest Rate Caps & Floors, Interest Rate options, Exotic Derivatives
- Bills and Commercial Papers
Also, refer the 1st part of the stock gyan series for having better understanding of the sequence and types, sub types etc.
Let’s come to the next category of Financial Instruments under Short Term Debt Asset Class. The name of this category is Exchange-Traded Derivative Category under which we will discuss about Short-term interest rate futures.
Meaning of Interest Rate Future:
An interest rate future is a futures contract with an underlying instrument that pays interest. An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.
Interest rate futures are used to hedge against the risk that interest rates will move in an adverse direction, causing a cost to the company.
What NSE says about Interest rate futures?
An Interest Rate Futures contract is “an agreement to buy or sell a debt instrument at a specified future date at a price that is fixed today.” The underlying security for Interest Rate Futures is either Government Bond or T-Bill. Exchange traded Interest Rate Futures on NSE are standardized contracts based on 6 year, 10 year and 13 year Government of India Security (NBF II) and 91-day Government of India Treasury Bill (91DTB). All futures contracts available for trading on NSE are cash settled.
For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship between interest rates and bond prices to hedge against the risk of rising interest rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a profit can be made when closing out of the future (i.e. buying the future).
The issuer pays the holder of the Bond the money when the Bond matures.
Suppose, The face value of both the Bonds which are underlying in case of the IRF’s is Rs.100.
Along with the face value, the other component is the coupon or interest amount that the holder of the Bond gets paid either annually or semi-annually.
Now, If you have invested Rs 100 at face value in an 8% GOI Bond, maturing 10 years from now with a semi-annual coupon, you get Rs 4 (Rs 8/2, Rs 8 is 8% of Rs 100 invested) every 6 months for the next 10 years, and get back the Rs.100 on maturity after 10 years.
Effect of Inverse Relationship between interest rates and bond prices:
- If interest rates are going up, “Short” Interest rate futures (you profit because when interest rates go up, Bond prices come down).
- If interest rates are going down, “Buy” Interest rate futures (you profit because when interest rates go down, Bond prices go up).
Interest Rate Futures in India:
Currently, Interest Rate Futures segment of NSE offers two instruments i.e.
- Futures on 6 year, 10 year and 13 year Government of India Security (NBF II) and
- 91-day Government of India Treasury Bill (91DTB).
The NSE Bond Futures II (NBF II) contracts are available for trading based on Government of India (GOI) security of face value 100 with semi-annual coupon and residual maturity between 4 and 8 years, 8 and 11 years and 11 and 15 years on the day of expiry of IRF contract, as decided by stock exchanges in consultation with FIMMDA.
Three Serial monthly contracts followed by three quarterly contracts of the cycle March/June/September/December will be made available along with functionality for spread contract trading on the NSE electronic trading platforms.
The NSE trading system called ‘National Exchange for Automated Trading’ (NEAT) is a fully automated screen based trading system, which adopts the principle of an order driven market.
Here we end this part.
In the next part we will discuss about the Next category of short term debt asset class i.e. OTC derivatives under which we will discuss about Forward rate agreements.
So, don’t miss it.
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